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Fiscally Unfit

From Washington Lawyer, April 2011

By Anna Stolley Persky

Now that the United States appears to be slowly climbing out of the recession, one thing has become increasingly obvious: our nation faces a mountain of debt. In January the Congressional Budget Office projected a nearly $1.5 trillion deficit for 2011, equaling 9.8 percent of the country’s gross domestic product (GDP). Our federal debt of about $13.9 trillion grows by almost $4 billion every day.

For this country to thrive again, or perhaps to even merely survive, many economists say the federal deficit must be addressed. The political debate focuses on when and how we approach balancing the budget and paying off the debt. There are some in Congress who advocate waiting until the economy is convincingly healed, and others who say we must cut spending radically and decisively.

“The deficit is a great, big leg iron that we’re dragging behind us,” says former Republican U.S. Rep. James T. Walsh, a government affairs counselor at K&L Gates LLP. “It’s slowing this country down, and we’ve got to somehow free ourselves of it. The public is realizing this is a big issue, and they want to see the government do something about it.”

At the end of 2010, a financial task force formed by President Barack Obama announced that immediate action was necessary. The National Commission on Fiscal Responsibility and Reform released a list of recommendations that could stabilize debt by 2014 as well as reduce debt to 60 percent of the GDP by 2023 and 40 percent by 2035.

The commission’s report, titled “The Moment of Truth,” includes a number of controversial ideas such as raising the retirement age, reforming the tax system, cutting military spending, and revamping Medicare.

In his State of the Union address in January, Obama pushed for a five-year freeze on discretionary domestic spending that would cut the deficit by more than $400 billion over a decade. But despite his stated concerns, a month earlier Obama and Congress extended the George W. Bush-era tax cuts, set to expire at the end of 2010. The deal also included an $858 billion package to further stimulate the economy over the next two years.

“There was broad agreement that failing to extend at least some of the tax cuts would have had an adverse effect on the recovery,” says Philip R. West, a partner at Steptoe & Johnson LLP and chair of the firm’s tax practice. “But that meant that the deficit wasn’t addressed. When you have a war like we have, and then tax cuts on top, nobody should be surprised that the deficit is where it is.”

Some vocal members of Congress have been pushing for quick action on the deficit and even talking of doing so in a bipartisan manner. Sen. Mark Warner of Virginia, a Democrat, and Sen. Saxby Chambliss of Georgia, a Republican, have been moving forward with the commission’s recommendations. In fact, for months they have been leading a group of more than 20 senators in a discussion on what needs to be done to reduce the deficit. Incidentally, both senators voted in favor of the tax cut extension.

Many economists applaud efforts to cut the deficit, urging lawmakers to go beyond endorsements and rhetoric and into the actual business of addressing spending. While the American people say the deficit is one of their primary concerns, some observers familiar with the legislative process question whether legislators will actually be able to accomplish a compromise solution. And even if Congress can compromise to reduce the deficit, will they have the backing of the American public when the time comes to face the budget cuts that would necessarily be part of any solution?

“What the economy has needed for the last couple of years is short-term fiscal stimulus, and, at the same time, measures to lock in long-term progress toward fiscal responsibility,” says Jeffrey Frankel, an economics professor at Harvard University’s John F. Kennedy School of Government. “It ought to be possible to get this message across, but the message has been lost.”

When Deficits Matter
Before analyzing the various theories regarding the deficit, it is important to understand what a deficit is and how it is different from, but related to, the national debt. The deficit is the amount by which the government’s expenditures exceed its tax revenue. To make up the difference, the government borrows from a variety of sources, including foreign countries. Any amount the government must borrow becomes part of the federal debt.

The U.S. Constitution does not mandate a balanced budget, but it does require Congress to approve all federal expenditures. The Constitution empowers the federal government to raise revenue through taxes, tariffs, and other measures; it also authorizes the government to incur debt.

Right now the federal debt is the largest in the world, approaching $14.3 trillion. Nearly two-thirds of it is public debt owed to businesses, individuals, and foreign governments that bought treasury bills, notes, and bonds. Of the total $4.3 trillion in foreign holdings, China and Japan owned the most as of last year at 21 percent and 20 percent, respectively. The remaining federal debt was borrowed from parts of the U.S. government, including trust funds such as Social Security.

Most economists and lawyers involved in the budget process insist that it is necessary for the country to be able to run a deficit, especially in times of war.

“The federal government needs the flexibility to run deficits at critical economic times to support the country,” says Rich Gold, a partner at Holland & Knight LLP and a specialist in the federal budget process. “But it should only be episodic. It should not be permanent.”

The question then becomes: how long can the government continue to operate at a deficit and with an accumulating federal debt? While Congress can set a debt ceiling, it also can extend it, as it does periodically.

There is certainly a minority viewpoint that running a government on a deficit has little or no impact on the economy. But most economists agree that there will come a time when other countries will no longer lend to a risky investment. And, eventually, money borrowed from trusts such as Social Security will have to be repaid, or the system has to be changed to accommodate the lack of funds.

“At some point, deficits matter. If paying your debt service exceeds some of your larger discretionary programs, you’ve got a problem, and we are certainly heading in that direction,” says Gold, who heads Holland & Knight’s public policy and regulation practice group. “Deficits that go on for a long period of time can be destructive for carrying out the business of the government.”

The problem, experts say, is that nobody can pinpoint the exact moment when the deficit will drag the country into a crisis. “Right now it seems to be tolerable. We won’t know the impact of the deficit on our ability to borrow until suddenly we can’t borrow anymore, if that happens,” West says.

Long History of Shortfalls
Worries about the federal deficit are nothing new. Over the years the United States has had surpluses and deficits, with debt accumulation during wartime. The government incurred considerable debt during both the Civil War and the Spanish–American War. However, in both cases, the government managed to pay off the debt relatively quickly.

In the early part of the 20th century, the budget usually was balanced. But with the Great Depression and then World War II, the government had a string of budget deficits. Federal debt jumped from $16 billion in 1930 to $242 billion by 1946. Still, the government slowly paid off much of the debt.

What caused the deficits and what helped and hurt the country’s economy during that time are still the subject of debate among economists, historians, and politicians today. “My understanding is the deficits were brought down during the times of greatest prosperity,” Steptoe & Johnson’s West says. “But the same evidence may lead different people to different conclusions.”

The next decades brought a variety of federal budgets, sometimes balanced, sometimes not. In 1974 Congress passed the Congressional Budget and Impoundment Control Act, which governs the budget process.

During his inaugural address in 1981, President Ronald Reagan spoke about the national debt, a topic on which he had often opined on the campaign trail. At that point, the national debt was just under $1 trillion.

“For decades we have piled deficit upon deficit, mortgaging our future and our children’s future for the temporary convenience of the present,” Reagan said. “To continue this long trend is to guarantee tremendous social, cultural, political, and economic upheavals.”

During Reagan’s first year in office, the country was fighting high inflation coupled with weak economic growth. Congress then passed the Economic Recovery Tax Act of 1981, which cut individual tax rates, increased estate tax exemption, and trimmed taxes paid by businesses. Thereafter, Reagan and Congress raised taxes 11 times, ultimately bringing back about half of the 1981 tax cuts.

The country experienced a period of economic recovery and growth during Reagan’s two terms in office. But his administration and that of President George H. W. Bush struggled with balancing the budget. Between 1983 and 1992, the national deficit averaged $206 billion a year.

Trickle-Down Deficit
Experts provide a variety of reasons for Reagan’s deficit record. Some blame the Reagan administration for combining tax cuts with increased defense spending and little cuts elsewhere to compensate. But by lowering taxes, Reagan, according to Gold, was attempting to force the Democrats to reduce the size of government programs.

“Reagan’s major philosophical contribution has been that if you cut taxes and reduce revenues so much that the Democrats can’t fund all the things they need to fund, eventually it will force them to reduce the size of government,” Holland & Knight’s Gold says. “It didn’t work.”

In 1985 Congress passed, and Reagan signed, the Balanced Budget and Emergency Deficit Control Act, also known as the Gramm–Rudman–Hollings Act, in connection with a measure that raised the national debt ceiling.

The act specified a schedule for declining deficit targets, with a balanced budget required by 1991. In addition, it required Congress to compensate for tax cuts or spending with other revenue, and provided for automatic spending cuts if Congress and the president failed to come within $10 billion of the targets specified in the law. The U.S. comptroller general, head of the General Accounting Office (now the U.S. Government Accountability Office), was assigned the job of determining whether the budget met the required targets.

In 1986 the U.S. Supreme Court, in Bowsher v. Synar,[1] found that the comptroller general was subservient to the legislative branch, and yet performing duties belonging to the executive branch. The Court concluded that this part of the law was an unconstitutional breach of the separation of powers doctrine. Thereafter, Congress revised the Gramm–Rudman–Hollings Act, but it still failed to prevent deficits.

Under the Clinton administration, the deficit was reduced and the economy boomed. In 1993 Clinton pushed through a tax increase. At the same time, total government spending slowed. During this time, Congress passed the Balanced Budget Act of 1997, intended to help control the amount of government spending.

In the Red Again
When Clinton left office in 2001, there was a federal budget surplus of $127 billion. There is wide debate as to why the economy performed during the late 1990s and why the deficit finally was successfully reduced. Some credit the Republican Congress for slowing down federal spending; some say it was the tax increases. Others say Reagan’s economic philosophy led to the later gains.

“When the Republicans won the majority in 1994, the primary thrust was to balance the budget, and we did,” says Walsh, who served 20 years in the U.S. House of Representatives. “President Clinton worked with us and deserves some of the credit, but the president ultimately has no control over the budget. Congress does.”

But according to Steve Bell, senior director of the Economic Policy Project at the Washington, D.C.-based Bipartisan Policy Center: “In the end, deficit reduction was not the foremost thing on President Reagan’s mind.” Bell, former staff director of the Senate Budget Committee, adds, “The most important thing to him was to increase dramatically the defense budget. Deficit reduction was, for Clinton, the most important thing.”

When President George W. Bush took office in 2001, the national debt was $5.73 trillion. He initiated a 10-year, $1.6 trillion package of tax cuts in 2001 and a follow-up $350 billion package of cuts in 2003. At the same time, the federal government was expanded with the creation of the U.S. Department of Homeland Security, and the defense budget was ramped up in response to the wars in Iraq and Afghanistan. Bush had a series of budget deficits.

During Bush’s first term, Vice President Dick Cheney allegedly said to former Treasury Secretary Paul O’Neill that “Reagan proved that deficits don’t matter.”

“The reality is that the deficit was under control going into September 11,” Gold says. “President Bush reduced the revenue side and increased spending with things like the creation of the Department of Homeland Security. And that’s why we are here today. From a deficit perspective, he was a disaster.”

But as Walsh sees it, Congress and the president were “reacting to the attack on our country.” “We strengthened homeland security. It was very expensive and it was absolutely necessary at the time,” Walsh says. “And now it needs to be reevaluated.”

When the economy began to crumble in 2008, Congress passed—and Bush signed—a $700 billion bank bailout and a $168 billion stimulus package. By the time Bush left office, the national debt had increased to $10.63 trillion. The budget deficit for 2008 was $458.6 billion.

“There were very big tax cuts, a rapid increase in spending, and two recessions that started during Bush’s watch,” Harvard’s Frankel says. “President Obama inherited a very high level of debt and the worst financial crisis and recession since the ’30s.”

A Look at America’s Checkbook
When President Obama took office in 2009, he enacted a $787 billion stimulus package. The federal deficit for 2009 was a record $1.416 trillion, a sum that Democrats claim was inherited from the Bush administration. Last year the deficit came in at $1.3 trillion as stimulus spending fell and revenue began to recover.

In January the Congressional Budget Office reported that the budget deficit this year—projected at $1.5 trillion—would be the highest this country has ever seen and that the national debt, if left unchecked, would equal 77 percent of the GDP by 2021.

In February 2010, Obama established the bipartisan National Commission on Fiscal Responsibility and Reform, “charged with identifying policies to improve the fiscal situation in the medium term and to achieve fiscal sustainability over the long run.” At the time, pundits and congressional leaders alike doubted whether anything could be achieved with the commission’s creation.

“When the commission was appointed, most people didn’t think it would be a success story,” says Maya MacGuineas, president of the Committee for a Responsible Federal Budget. “Everybody was playing politics with it, but, much to everyone’s surprise, they pushed along this plan, created with members who had nothing in common.”

The commission’s report, “The Moment of Truth,” states that the country’s leaders “have a responsibility to level with Americans about the choices we face, and to enlist the ingenuity and determination of the American people in rising to the challenge.”

The report discusses reforming Social Security and extending the retirement age, changing the Medicare reimbursement formula, and cutting other areas of discretionary spending. The commission also called for tax reform, which includes increasing revenue by reducing tax deductions and exemptions.

So–called deficit hawks, individuals and groups that have been warning about a looming economic doom, applauded the “courageous” commission for addressing the problem with naked realism. MacGuineas calls the report “the most serious, credible plan I ever could have imagined.”

“It doesn’t leave any sacred cows,” MacGuineas says. “It is filled with things that people don’t like, but that must be done. The commission deserves the gold star, the blue ribbon, and the medals of courage and honor.”

She credits the report for helping the American people understand the urgency of the issue. “What was once considered a long-term problem has become more of an immediate problem. We have a timeframe of five years instead of two decades,” MacGuineas says. “And it has become something that the public is really aware of.”

Old-Fashioned Fix
Some economists, a little more reserved in their praise, say the commission did not come up with many new ideas, but said the obvious. Hopefully, they say, the message will finally produce action.

“What the commission said is basically what most economists have been saying for quite some time—the longer we delay, the more spending programs we will have to cut and other measures we will have to take,” says Frankel of Harvard’s Kennedy School of
Government.

Thomas A. Schatz, president of the Washington, D.C.-based Citizens Against Government Waste, says that while the commission “raised the visibility of the severity of the debt and the problems we face,” its recommendation of increasing revenue concerns him. “We don’t want to even talk about raising revenue to balance the budget,” Schatz says. “When money comes in, Congress tends to spend it.”

It is difficult to find someone involved in the budget-making process who thinks the federal debt can be completely ignored. But some budget experts say that now is not the right time and there are varying opinions on the correct course of action to address the issue.

“A lot of smart people think we need to do more to stimulate the economy first,” says Steptoe & Johnson’s West. “Cutting spending at this point may not be the right thing to do.”

But while most observers say that spending cuts could be helpful in reducing the deficit, some economists and lawyers specializing in the federal budget emphasize a different philosophy: economic growth leads to deficit reduction.

“We’re going to address the deficit the old-fashioned way—we’re going to earn our way out of it,” West says.

The theory is this: Once people start making more money, they will pay more taxes, which then goes toward controlling the deficit. Given that the economy needs to thrive, our focus, they say, should be on encouraging the growth of new jobs and increasing earning potential.

“The reality of the situation is the economy is going to come back,” says Gold of Holland & Knight. “The federal government gets the bulk of its revenue off of income taxes, so while right now the deficit is big, it will shrink significantly simply based on revenue coming back.”

Bipartisan Effort
Some members of Congress have been striding forward with efforts to address the federal deficit. In fact, months before the commission’s report, Senators Chambliss and Warner quietly held meetings with an ad hoc working group. They have talked with top economists, including Federal Reserve Chair Ben Bernanke and former Comptroller General David Walker, exploring ways to curb the national deficit.

The meetings have included senators from different ideological backgrounds such as Bob Corker, a Republican from Tennessee, and Amy Klobuchar, a Democrat from Minnesota. Warner has said that they’ve called “a cease-fire on immediately criticizing each other’s ideas.”

During a news conference late last year, Chambliss and Warner said there is “no silver bullet” to fix the country’s problems. The senators said they will consider all options, including unpopular ones, as they determine how best to fix the federal budget. “The way you do it is put everything on the table,” Chambliss told a press gaggle gathered in December 2010.

Some of the group’s discussions focused on revamping the current tax system. Chambliss also is a proponent of FairTax legislation that would replace the current income tax system with a nationwide sales tax system.

In Washington, there’s a widely held belief that, for the moment, the American people truly are concerned about the accumulating federal debt. After the elections, which brought Republicans back into power in Congress, some pundits said the voters were sending a message: stop spending and address the deficit.

As Washington Lawyer went to press, Congress has yet to vote to lift the debt ceiling. The coming months likely will trigger an intense debate, with some Republicans calling for a $100 billion cut in domestic spending.

“The big question is whether those who campaigned in November on a platform of reducing the government and the deficit, will they talk big and then do the opposite?” Frankel says. “It’s not about big government versus small government, or liberal versus conservative. It’s about making speeches versus making hard choices that will actually solve the deficit problem in the long run.”

Candidates for Cuts
While most economists agree that a balanced budget is necessary, and most members of Congress call for one, theories abound as to which route is the most effective way to proceed, both politically and practically. What would even work?

Frankel emphasizes that broad cuts and taxes will be necessary, as suggested by the National Commission on Fiscal Responsibility and Reform. “It’s simple arithmetic—the big money is either taxes or entitlements like Medicare, Social Security, and then defense,” Frankel says. “Raising the gas tax to European levels would go a long way, for example.”

While advocates of cutting taxes say this method will stimulate the economy, others disagree, arguing instead that the government needs the increased revenue that higher taxes could bring. At any rate, West, who follows discussions on Capitol Hill over tax policy, says he does not predict any major overhauls of the tax code or change in policy in the next few years.

The commission’s report states that every government program should be scrutinized for spending cuts. One of its most controversial proposals concerns Social Security reform. The commission specifically suggests revising the benefit formula that slows future benefit growth, particularly for the higher wage earners. In addition, the commission proposes gradually raising the minimum retirement age.

For West, the commission’s proposal on Social Security makes a lot of sense. “On the question of Social Security, my personal view is that I don’t understand why the wealthiest of Americans should be getting the same benefits as the neediest,” West says. “It’s reasonable and important to put Social Security, along with everything else, on the table. If we’re serious about it, to make a dent on the spending side, then we will have to make real cuts that people will notice.”

Obama’s 2012 budget proposal, however, offered no major
changes to Social Security. Observers predict that changes won’t come without a fight as the Baby Boomer generation faces retirement.

Call for Compromise
The Bipartisan Policy Center has come up with a proposal intended to appeal to centrists in both parties. The center is proposing to flatten the tax code, go to a voucher system for Medicare, turn Medicaid over to the states, put a five-year freeze on defense and security-related spending, put a four-year freeze on all domestic discretionary appropriations, and close the existing loopholes in the federal tax code.

But the changes would be put on hold for at least a year, says Bell, the center’s senior director. “We recognize that this recovery is still fragile, so our plan specifically calls for a time to continue this recovery and then make the changes.”

The center’s proposal has been discussed on the Hill, and Bell is hopeful that it will gain support as Congress tries to figure out which approach to take. However, Bell is concerned that Congress will ignore the proposal, fail to act, and instead “do the old kick the can down the road.”

Some observers such as Andrew Pike, director of the Law and Business Program at American University Washington College of Law, are optimistic that this time may be a little different, that Congress may actually be able to compromise.

“It seems like there’s something in the air that says that fiscal responsibility is something more than a platitude,” Pike says. “Whether they can overcome their political instincts, that remains to be seen.”

Walsh says he is “hopeful,” adding: “Most people in Congress have a very pragmatic view of problem-solving.”

And for those who believe that when the economy returns the deficit will shrink, Congress need not agree on drastic changes. Gold is hopeful that members of Congress do just that—“agree on a modest package.”

“They will look like heroes because in addition to whatever cuts they can instill, they can take credit for increased revenues,” Gold says.

Driving Home the Message
One question is how to ensure the public is on board with any changes and sacrifices that would necessarily come with any attempt at massive spending cuts. As observers put it, the American people want to have it all—a deficit reduction plan that does not affect their individual bottom lines.

“We are very much a ‘me, me, me’ generation right now,” Gold says. “In 2010 the people punished Democratic elected officials for bailing out the banks. They said, ‘I need a bailout! Why am I paying for everybody’s bailout when I needed one?’”

In his State of the Union address, Obama seemed to emphasize jobs over conquering the deficit. However, Obama also warned the American people that spending cuts also would be necessary. Still, deficit hawks have expressed frustration that Obama has not been strongly voicing his concern over the deficit.

In February Obama released a proposed $3.7 trillion budget for 2012, with cuts in Pell Grants for college summer classes, but an overall increase in education. The Obama proposal would also cut funding for environmental protection and defense.

However, the spending plan would still result in a $1.1 trillion deficit in 2012. Obama’s proposal has been criticized as failing to address entitlement spending.

“The president’s budget was an overly timid opening bid on the budget discussions that have been unfolding,” says MacGuineas of the Committee for a Responsible Federal Budget.

But, crucially, the public has to be willing to sacrifice in the short term for the long-term benefit of a balanced budget, according to deficit policy experts.

“It used to be a politician could give a speech saying that these are tough times and everybody is going to have to pull together and give up something,” Gold says. “The word ‘sacrifice’ doesn’t come up much these days in political speeches. The public doesn’t want to hear about sacrifice.”

That being said, Obama, in his State of the Union address, indeed called upon the country to sacrifice. According to Gold and others, this refrain should be repeated over and over until Congress, the country, and the president himself truly understand it.

“There’s only one person who can really get the message across to the American people,” Bell says. “And that’s the guy who has the bully pulpit.”